data centers face a growing number of external factors that...

Je� Tuthill and Michael Allen

Data Centers Face a Growing Number of External Factors That Can Lead to In� ated Property Taxes

IntroductionThe valuation of data centers for real and personal property tax purposes can be a

special challenge for local assessors because of their unfamiliarity with this unique

property type. They often pose special valuation problems for assessment purposes.

Failure to fully appreciate and consider all negative impacts on value from external

factors often leads to � awed valuations and in� ated property taxes.

Did You Know…

The average number of data centers will increase to 10.2 per organization through

2021. Moreover, new data center construction is expected to grow more than � ve

times in that same time.

SOURCE: Cisco Visual Networking Index, “State of the Data Center Industry” (2018)

CONTENTS

Introduction 1

Data Centers Are a Unique Type of Commercial Real Estate 2

The “Powered Shell” Is the Key to Accurate Real Property Value 4

Real Property Taxation of Data Centers 4

Cost Approach: The Easiest Way to Value the Powered Shell 5

Estimating Obsolescence Di� cultiesin Data Centers 6

Impact of the Cloud on Applicable Depreciation for Data Centers 8

Impact of “Patent Troll” Litigation 9

Conclusion 11

Data centers have historically been incorrectly assessed for real property taxation.

Valuation Concerns and Challenges for Today’s Data Centers | 1

Data Centers Are a Unique Type of Commercial Real EstateAll data centers are essentially buildings that provide space, power, and cooling for network

infrastructure. They centralize a business’s information technology (IT) operations or equipment,

as well as store, share, and manage data. Businesses depend on the reliability of a data center to

ensure that their daily IT operations are always functioning. As a result, security and reliability are

often a data center’s top priority.

Although many taxing authorities consider all data centers to be basically the same, there are

many di�erent types of facilities and service models. Understanding di�erences in their use and

business models helps avoid valuation miscalculations. A one-size-�ts-all approach can create

numerous valuation errors.

The following list helps clarify the main di�erences in data centers:

In-House Data Centers (“Enterprise” Centers) – Many enterprises—especially larger

organizations and those in the technology industry—design, build, and operate their own

facilities. The capabilities of an in-house facility will depend on the investment the �rm is

willing and able to make.

Colocation Centers – An example of a multitenant data center/colocation space can be

sold or rented to enterprises by the rack, cabinet, or cage. Companies of all types and sizes,

from small- and medium-sized businesses to Fortune 500 �rms, bene�t from colocation

services. Customers still maintain control over their hardware but outsource facility and

internal systems maintenance to the provider. The tenant’s leased space can easily expand

or contract as needed.

Wholesale Data Centers – These providers sell or rent data center space in larger capacities

than a colocation model and typically have fewer customers. They may build-to-suit a space

for a single tenant. The concept is like leasing a warehouse or o�ce space in which the

landlord provides facility maintenance to the tenant.

Dedicated Hosting – The provider operates and/or rents server capacity to single

customers. In other words, servers are not shared among multiple customers. No additional

services are provided, and the customer maintains full control over the server beyond

maintenance. However, some providers can add amenity services, such as remote hands to

reboot servers and upgrade software.

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Managed Hosting – In a managed hosting facility, the provider operates servers

and storage for its customers, as well as provides additional administrative and

engineering services. Although the scope of services can be diverse and extensive

among the various providers, some common examples include database

administration, operating system administration, managed security services,

managed storage, application management services, disaster recovery, systems

monitoring, and remote management. The hardware may be owned by the customer

or the provider.

Shared Hosting – In this example, customers share server capacity. Well-known

website hosting companies such as GoDaddy and Network Solutions represent

examples of providers operating shared hosting facilities. To deploy services, these

providers create a user interface overlaying the physical server. This interface provides

multitenant applications to help customers con�gure their services.

These are a few of the most popular data center facilities operating today. However,

numerous service models exist, and the line between di�erent types of operations can

become blurred.

Each type of data center is con�gured, equipped, and operated di�erently depending

upon its intended use. However, there is a common denominator that always presents and

re�ects the real estate base upon which everything else is customized—the Data Center

Powered Shell.


The Powered Shell Is the Key to Accurate Real Property ValuationA data center’s ad valorem real property taxation is usually best determined by valuing only its

Powered Shell.

By valuing only the Powered Shell of the data center, the most common valuation errors caused

by commingling the value of any personal property and/or business enterprise value (intangibles)

with the real estate can be avoided. The Powered Shell alone is as close as you can typically get to

arriving at an estimate of the value of the real estate alone associated with a data center, whether

fully complete, occupied, and/or operating at its full potential.

Real Property Taxation of Data Centers An operating, mature, and fully leased/operating data center commingles several di�erent types of

values and assets. These include real property, tangible personal property, and intangible personal

property. When combined, the value of all those assets in the aggregate represents the value that

a typical investor will pay for the entire functioning enterprise [i.e., Business Enterprise Value (BEV)].

It is not always easy to extract only the real estate component of value from the entire BEV. Failure

to do so can often lead to double taxation between real and personal property or an unsupported

over/under allocation of BEV to the real estate. This can lead owners, tenants, and users to be

overcharged because most real property tax is passed on in one way or another.

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A Powered Shell data center is a facility with all exterior construction fully completed, with available power and connectivity, but with the interior left as raw space to be finished by the customer or to meet a potential customer’s specifications.

However, real property taxes are only paid on the segregated value of the real estate alone.


Cost Approach: The Easiest Way to Value the Powered ShellOf the three established approaches to valuing commercial real estate—Income, Sales,

and Cost—the Cost Approach can easily be applied to the valuation of Powered Shells and

excludes any portion of the BEV and personal property.

Although the Cost Approach is a relatively simple valuation method to arrive at the real

estate only value of the data center, in some cases, an Income Approach can be an e�ective

tool in valuing a Powered Shell if the appropriate assumptions can be identi�ed. Typically,

this would be done on a market basis rather than using actual income and expense from

leases in place to minimize the amount of BEV captured in the capitalized income stream.

However, because those are market-extracted assumptions, they will never be entirely free

from some return on and of the non-realty assets being provided.

Most often, the Cost Approach is easier to use because its assumptions are more readily

available, particularly if the subject facility is relatively new.

Under the Cost Approach, the value of the underlying land and site improvements is �rst

estimated separately based on recent sales of similar land and/or using cost estimation

guides. Then the replacement cost new of the Powered Shell is estimated based on

actual construction costs or construction guides such as Marshall & Swift. An appropriate

adjustment for depreciation is applied to get to the depreciated value of the improvements,

which represents present value estimate of the property as a Powered Shell only.

There are di�erent types of depreciation (i.e., Functional, Physical, Economic/External) that

can be applied to a data center. The depreciated building value is added to previously

established land and site values, plus an estimated entrepreneurial pro�t, to get to the �nal

Cost Approach value conclusion. There should be little, if any, BEV or personal property

contained in that estimate.

Accordingly, this Cost Approach value estimate should be used to establish real property

taxes for the entire data center if all the realty improvements to the Powered Shell are fully

captured in that estimate (e.g., back-up generators, utility connections, etc.). This value

estimate should be used reliably and consistently by assessors in producing their proposed

real property assessed value of the data center. It is worth noting that in the event there is

excess land that has yet to be developed, upon which the data center sits, then to the extent

that this land can be independently developed from the existing data center, it also needs to

be valued using comparable sales. Any such excess land value needs to be added to the Cost

Approach by the assessor.

Most often, the Cost Approach is easier to use because its assumptions are more readily available, particularly if the subject facility is relatively new.

Estimating Obsolescence Di�culties in Data CentersA considerable amount of care needs to be taken in applying the various depreciation

adjustments. The older the building, the harder this is to do accurately. Some of the most

pertinent types of depreciation common in data centers are physical, functional, and external/

economic obsolescence.

Physical

Physical obsolescence is generally de�ned as any loss in value to a property related to accrued

wear and tear (combination of use, e�ects of aging process, physical decay, structural defects, and

action of the elements).

Key indicators to consider are:

Electrical Supply to the Facility (i.e., amount of kilowatts, max capacity)

Condition of Exterior Walls

Condition of Interior

Mechanical Equipment Condition

Roof Condition

Such obsolescence can be curable or incurable. In data centers, physical and functional

obsolescence can overlap because each may be the result of diminished market demand due to

the amount of kilowattage delivered to the property and/or its current con�guration to leverage

technology advancements.

Functional

What is functional obsolescence?

“Functional obsolescence is the impairment of functional capacity of a property

according to market tastes and standards.” – De�nition from The Dictionary of Real

Estate Appraisal, Fifth Edition (Appraisal Institute).

In other words, it includes any loss in value to the property because of something occurring

within the subject property’s boundary:

Improved too much: Over-improvement for the demand of the market

Improved too little: Under-improvement for the demand of the market

If you are uncertain of that answer, that is a clue there is functional obsolescence at the

property. The test should always be to ask the question, “What is the perceived market reaction

to the subject property in either utility or desirability as currently constructed, con�gured, and

equipped?”

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When you are dealing with functional obsolescence, one critical question you must �nd

out is whether it is curable or incurable. The rule of thumb is whether the cost to �x the

problem can be justi�ed by the potential increase of property value. In other words, is the

juice worth the squeeze? If not, you need to make this depreciation adjustment.

For data centers, examples of functional obsolescence can include:

The impact of users/clients migrating their data to the Cloud

Their appetite for larger facilities

The consolidation of their data in fewer facilities

Privacy concerns and legislative protection that can make going

o�shore desirable

External/Economic

The de�nition of external obsolescence is often stated as any defect, always incurable,

caused by negative in�uences outside a site, and it is incurable by the owner, landlord,

or tenant. Otherwise stated, it is any loss of value from a source outside the property itself

or caused by any external factors that a�ect potential economic returns, thus having a

direct impact on the market value of a property.

The three basic categories of external obsolescence are:

1. Economic In�uence,

2. Environmental In�uence, and

3. Locational In�uence.

Two good examples of this type of depreciation that is almost never considered by the

assessor in the assessment process or in determining data center taxation are the growing

impact of the Cloud and certain legal decisions with unintended consequences. A very

good recent example is how the “patent troll” court jurisdiction issue is a�ecting portions

of the North Texas data center market.


Impact of the Cloud on Applicable Depreciation for Data CentersData centers have changed considerably since they �rst became common in the late 1990s.

Similarly, the servers that operate within a data center are smaller and require much less cooling.

This has allowed data center design to become more uniform and compact. Accordingly, there is

a signi�cant di�erence between the early 1990’s designed data centers and those that are being

constructed today. In particular, today’s data centers are much larger and uniform, and often

there is excess land purchased contiguous to the data center to accommodate future expansion.

In the past, enterprise-level data centers were constructed to meet speci�c corporate functions

and capabilities. The requirements of the Cloud have driven a new uniformity in design, which

makes facility planning and con�guration an easier task.

Typically, older-generation data centers su�er from signi�cant and multiple obsolescence

because of over-improvement and/or out-of-date design criteria. A review of recent sales of older

data centers, which were con�gured for the requirements of the 1990s, shows that, in many cases,

their sales prices represented less than 20% of their original cost. However, until they were sold,

assessors routinely refused to accept the impact of the accrued depreciation on their value for

property tax purposes.

Furthermore, there has been a negative impact to the value of tangible personal property located

within the data center. In particular, the design and utility of server equipment has evolved so

dramatically and quickly, because of the needs of the Cloud, that older equipment has little or no

resale value. This in part is a result of the ever-increasing processing power of today’s equipment.

All of these factors can combine to cause older, larger data centers to have large blocks of unused

power capacity and/or ine�cient deployment of equipment within the data center. This a�ects

value and should be re�ected in the property tax assessment.

In summary, the data center industry is evolving to meet the demands of the Cloud and that will

likely have a signi�cant impact on the value of all data centers, particularly those that are older

and smaller.

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Impact of “Patent Troll” LitigationThe impact of external/economic obsolescence can be caused by all types of obscure

events. For instance, there is a growing national concern that forum shopping plainti�s

looking for favorable venues to support patent infringement cases have had an unexpected

and negative impact on certain data centers.

Currently, its impact is being felt primarily in certain parts of Texas, but the phenomenon

is likely to spread to other areas of the country where local courts are perceived to favor

plainti�s who are forum shopping in patent infringement cases. The impact is to cause

individual businesses or industries to move out of that location and eventually out of the

data centers previously occupied and used there. The plainti�’s argument is that if the

defendant is operating or leasing space in a data center within that jurisdiction, there is

su�cient nexus for the plainti� to sue for patent infringement.

A good example is Apple’s recent and surprising decision to close all its stores and

operations in Plano, Texas in favor of opening a store in nearby Dallas in The Galleria Mall.

Apple did so for fear of being otherwise deemed to be doing business in Collin County

and giving patent litigation jurisdiction to the Courts of the Eastern District of Texas. This

move has worried the data center industry with major investments in Texas cities such as

Richardson, Plano, and Allen.

The background to Apple’s decision is that on May 22, 2017, the U.S. Supreme Court

unanimously found in favor of TC Heartland, an Indiana-based company which had argued

that Kraft Foods should not have been allowed to �le suit in Delaware, which is another

hotspot for patent litigation, because of lack of nexus with that state. The court agreed.1

The ruling keeps patent infringement suits con�ned to districts where the defendant is

incorporated or has an already established place of business. Based on this decision, Apple

apparently hopes to avoid future patent infringement lawsuits by closing its stores in East

Texas.

This trend could have a negative impact on demand for collocation data center space in

Collin County, Texas, while concurrently driving increased demand for the value of data

centers in places such as the lucrative Dallas County data center market. Simply put, legal

counsel for potential data center users is now regularly instructing management and real

estate brokers to avoid leasing or operating in any data centers located in the Eastern

District Court of Texas if patent con�icts are likely.


1 TC Heartland LLC v. Kraft Foods, Group brands LLC, Docket No. 16-341, May 15, 2017

Ironically, many of the cities located in that district have long been known as tech hubs, housing

operations for stalwarts such as AT&T, Ericsson, and Cisco Systems. The “patent troll” issue is acting

as a sort of double whammy to landlords in the data center space in Collin County, Texas because

of the large amount of new data center capacity that has come online in the last few years.

As if the “patent troll” issue wasn’t enough of a blow, Datacenter Hawk™ reports in the �rst

quarter of 2019 that data centers located in the Dallas/Fort Worth market have had to be more

aggressively priced because of the availability of larger amounts of commissioned power that is

pushing rates lower.

It is not all bad news for companies facing these economic headwinds. While it is an undoubtedly

unpleasant time to be leasing kilowatts and megawatts in Collin County, there may be a silver

lining in the opportunity to reduce their real property taxes.

Any time external factors such as the “patent troll” issue a�ect the ability to lease space and/or

diminish demand (i.e., when economic/external obsolescence is at work), it should support a

good argument for a signi�cant reduction in current and future real and personal property tax

assessments.

For instance, the owner of a new, speculative data center in such an a�ected location can argue in

a property tax challenge not only for much lower market rents but also for an expanded lease-

up adjustment because of reduced market demand, as potential tenants eliminate any location

subject to Texas’s Eastern District Court jurisdiction.

Traditionally, the valuation issues surrounding data centers have been regularly misunderstood

by assessors. Assessors often regard them as merely “�ex” or warehouse industrial buildings.

Consequently, many jurisdictions still have their data center assessments pegged at well below the

original cost to construct the Powered Shell. Although advantageous to the property owner, this

valuation is also �awed.

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ConclusionOwners, operators, and tenants in data centers throughout the United States need to adopt a

proactive approach to challenge their proposed real property assessments. Such a proactive

approach should consider each of the following:

Value Powered Shell only to avoid including BEV and personal property in the real

estate only valuation

Use the Cost Approach to value the Powered Shell to get the true real estate value of

a data center

Fully adjust for functional and physical obsolescence, which can sometimes be

cured, but rarely so in data centers

Fully adjust for all types of incurable external obsolescence, including the more

obscure types like the impact of patent trolls, technological advances, and/or

changes to market forces, including demand

Failure to value anything other than the fully depreciated value of a data center’s Powered

Shell will lead to in� ated valuations and the property taxes based thereon.


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